Suckers And Transparency: Preventing Another Financial Crisis

from the can-we-outlaw-suckers? dept

In continuing to try to understand the root causes of the financial crisis, we find that the whole story just keeps getting more interesting. While lots of folks are trying to blame one single thing (free markets, regulations, greed, poor people, rich people, bankers, mortgage lenders, hedge funds, short sellers, the President, Congress, etc.), the truth is that almost all of those explanations aren’t just wrong, they’re highly misleading. The problems involve a whole bunch of different things that combined to create the incentives that resulted in this situation — and preventing it from happening again is hardly an easy proposition.

Finding the last sucker

Earlier this year, in talking about a highly questionable investment firm that was investing in startups, we wrote about how the venture capital game has always been about finding the last sucker to invest. It used to be the public markets, but when that dried up, apparently some VCs moved on to basically skirting public offerings by getting firms like the one described in the post to effectively trick unsophisticated investors out of their money and put it into a “fund” that then went to startups. It was the same process — but actually less regulated than the public markets, and much more open to fraud.

The more I read about and understand different aspects of the current financial crisis, the more it becomes clear that basically the same thing happened here, but just on a much, much larger scale. It was a giant game of hot potato, where folks were passing along toxic assets looking for the last sucker to take them — except the process of finding that last sucker became so valuable, that many of the firms in the business of finding new bigger suckers… found themselves. In many cases, the suckers were, in fact, unsophisticated investors like the school districts we described recently, but the various banks got so tied up in the process that they started betting on these things themselves.

Becoming the last sucker

While we’ve been trying to avoid the blame game, the more details come out, the more it looks like an awful lot of the trouble actually comes from the ratings agencies, such as S&P and Moody’s. As we discussed in the story about the school districts, the ratings agencies screwed up pretty massively, by taking collections of poorly rated loans, and effectively claiming that all together, they suddenly became low risk assets. At some level you can see where they were coming from. If they were basing their decisions on the idea that default rates were independent, then bundling a bunch of questionable assets is a potential diversification strategy. You’re assuming that only a small percentage will default, and you can look at historical numbers to figure out the risk. But, the problem is that these aren’t independent, and as defaults start happening it leads to more defaults — and the ratings agencies were simply fooled by their own models.

That’s the generous interpretation, at least. The other is that there was outright fraud going on at the ratings agencies, and there’s some evidence there was a fair amount of fraud. My guess is there was a little of both. The ratings agencies were pushed to rate these financial products highly, and so they created models that would support a high rating. Basically, rather than creating models that actually judged the risk, they created models that told them what they wanted them to say, because, in part, their business model depended on it. It was, as noted, garbage in, financial crisis out.

A lot of this becomes clear in Michael Lewis’ excellent (as usual) discussion with a hedge fund guy who recognized this early (and made quite a bit of money doing so). What’s fascinating is how much work even he had to do before he realized how fragile the whole setup was. When the financial crisis first went into full swing, many folks pointed the blame finger at hedge funds that were shorting bank stocks, like this guy. However, as the Lewis profile makes clear, he wasn’t to blame. He was accurately telling everyone that the financial system itself had been built on a myth — and the mythmakers were believing their own myth.

The end result is that the race to find that last sucker resulted in plenty of suckers being taken — but when there weren’t enough of those, the banks basically made themselves the next sucker in line, and convinced themselves that they weren’t suckers. While there was almost certainly some amount of fraud involved in all of this, part of the problem was that everyone started believing their own bogus models in order to convince themselves that there would always be a later sucker (or, even worse, that they didn’t need a later sucker).

So how do you prevent suckers?

And that leads us to the crux of the problem. How do you prevent suckers? At some point, you can just say, well it should be “buyer beware,” and to some extent I agree with that sentiment. But, when all of the other incentives are as screwed up as they were in this situation, then even the “aware” buyer finds that almost every single datapoint he or she is using is wrong. That’s what was happening here. You could look pretty deep at many of these assets and everything was saying they were solid, when the reality was they were not. In cases of outright fraud by ratings agencies, you can pull out the blame finger, but in many cases it wasn’t so much fraud as it was the “experts” deluding themselves. How do you stop defrauding suckers, when it’s the suckers defrauding themselves… and then earnestly convincing everyone else in the process?

Radical transparency

The one thing I keep coming back to as a solution is to put in place some aspect of radical transparency on pretty much all aspects of financial instruments, both on the debt side and the equity side. On the equity side, I’m surprised that more folks haven’t picked up on Umair Haque’s point that quarterly reports are obsolete and not nearly transparent enough. What if public companies provided ongoing reports that revealed a lot more than they do today. And, similarly, any debt instrument provided much more detail concerning what was actually making up the investment.

The reason school districts got stuck with worthless CDOs was because the information they got wasn’t transparent at all. Sure, the prospectus was a book three inches thick, but all that information was actually used to obscure what the product was. Hell, the districts thought they were buying actual bonds, not making a side bet on how those bonds would do (what the CDO actually represented). But if there were real transparency within these instruments, and everyone buying into them could easily understand what was actually at stake, then they wouldn’t be so reliant on ratings agencies and their crappy models. They’d be able to build their own models — or openly share and discuss models with others.

While there will always be some “last sucker” out there, we can limit the risk of such things by limiting the suckers as much as possible — and the way to do that is to become much more transparent and open with information.

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Comments on “Suckers And Transparency: Preventing Another Financial Crisis”

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Anonymous Coward says:

Re: Re:

Right, because a 2 billion dollar bonus is enough to make a 20+ billion dollar company go under.

Excuse me, but no.

Granted, CEOs are over paid. Perhaps deservedly so in some cases where they drove a company to success, but largely its just excess vice.

Even with that in mind, that is such a small contributing factor to the vast majority of the financial crisis many companies are facing its almost not worth talking about.

Reed says:

Does open source have application outside of software?

An open source style financial system would probably be the only way to prevent this sort of thing happening again. Complete transparency and disclosure available to everyone at anytime would do wonders for our society.

I think those in charge would resist this with all their might though. Could you imagine what would happen if they could no longer cook their books? It would be a scarier world for those who are used to making money due to other people’s ignorance.

Steve R. (profile) says:

Computing Our Way Into The Collapse

Lee Gomes has a good article in Forbes Computing Our Way Into The Collapse

He writes: “For starters, computers were instrumental in creating financial products that were so complex that we now don’t know how to value them. Then, they also aided and abetted the disaster by giving a veneer of statistical respectability to financial assumptions that, had they been put into plain English, would have been met with the scorn they deserve.”

This may be very unpopular, but we can minimize investing risk by simply prohibiting these “innovative” financial instruments. I agree that theoretically anything can be modeled, the problem is that at some point hard assets are simply being turned in “virtual” assets that are devoid of any real value. Limits do exists. Destructive engineering is great in the lab, but in real life do we want to destroy the economy to uncover the limits?

Joel Coehoorn says:

Good luck with that.

As P.T. Barnum said, “There’s a sucker born every minute.”

That’s just something I don’t think you’ll ever be able to minimize. If you make the information more transparent, you just end up with more information and someone somewhere will still have to create an abstraction so that people can understand it all. And the thing about abstractions is that, as we say in the software development field, they leak.

sheople says:

the blame game

1. Federal Reserve trying to be “the almighty economy twitcher” would not let the economy have downturns.
2. Greedy bankers & wall street tycoons getting Glass-Steagall repealed & other tweks to let them “get richer”
3. citizens of the U.S. letting our factories exported
4. Congressmen for letting our economy become 70% based on “what we spend”

Herbert Hoover says:


It is a pretty simple case of Ponzi redux. There are a couple of things that can be done:

1. Tie executive pay to longer term results. None of this yearly or quarterly cycle stuff. I’ve worked at a number of companies and have seen a good CEO work miracles, so the good ones are worth good pay. The bad ones though should NOT be rewarded.

2. Increase enforcement of fraud statutes. If somebody hawks CDOs as low risk and they turn out to be garbage, throw the crooks who sold and rated this stuff into jail.

anymouse government worker says:

Exec Pay set the scene

If company A’s exec makes 5 million last year, and the company is ‘worth’ 100 million, then when the ‘bubble’ inflates the value of the company to 1000 million, then the exec expects to be paid 50 million.

The exec’s today are doing the same work that the exec’s of the past were doing, except today they have better tools and assistants available, so why do we have to pay them 100x more than their counterparts were making 50 years ago? The answer is because they expect us to…. their pay has continued to grow at an abnormal rate compared to the actual economy (or for the value they are actually adding).

Greed 1 – ‘We the Sheeple’ 0

BullJustin (profile) says:

Deeper roots and broader solutions

In the 80’s the panacea to get out of the stagflation of the 70’s was deregulation. Under federal regulation, utilities (and other regulated companies) were held to a maximum profit (I believe for electric utilities it was 13%). This caused those companies to spend more on corporate infrastructure (tools, business processes, delivery, wages, training, benefits, etc) because the higher the cost of doing business the higher the profit the business could achieve. Everyone got a piece of the corporate pie.

Once these companies were deregulated they began squeezing more and more out of their business. This led to finding cheaper sources of materiel and personnel, thus outsourcing and off-shoring our production facilities. this led to lower quality products being forced upon us for the same price. Lower quality caused the same products to be bought more often, thus increasing the total cost of ownership for lower quality goods. The idea was that money, when consolidated at the top, would “trickle down” to those below. It didn’t.

The system fed off itself as long as there was surplus fat in the economy to feed on. Unfortunately gutting our ability to produce raw materials and finished products at prices that we could afford resulted in a leaner economy. When the land and housing sector, the last vestige of value in urban and suburban locales which are now home to over 50% of our population, began to collapse, the folks looking for the next sucker realized there was nothing left to feed on. They had effectively drained the American economy.

The middle class is disappearing. Some have moved into the upper class ranks (just look at the number of millionaires in 1980 adjusted for inflation and compared to today) but most find themselves irresistibly becoming lower class or working poor.

As dire as the current situation is, perhaps what we need is re-regulation and a flat tax. Force every American company or business that file taxes in the US to cap out at 15% profit. Every dollar over 15% net could be taxed at 85%. That would then force these companies to begin injecting their capital back into the economy rather than consolidating it for the shareholders. The flat tax should be tied to the poverty level, which changes annually, and should be the same for both corporations and individuals/families. A simple 15% income tax with no tax shelters on every dollar over 3 times the poverty level.

The poverty level for a 4 person household in 2008 is $21,200. If a person makes up to $63,600/yr then no tax. If a person makes $80,000/yr then they pay only $2460. If a person makes $2.5 million they would pay $365,460)

This would rather immediately do several things. Any businesses which can claim less than 15% profit and any individual under the 3xPoverty line would be safe from paying taxes. Those individuals who most need the money (those at or near the poverty line) would have access to it and we wouldn’t have to borrow it from China. Additionally, companies would no longer look for the cheapest way to do things and our infrastructure would begin to improve again. Companies would be willing to pay more for American made goods because it would allow them to make more money. Companies would still need to be fiscally responsible to be able to reach that 15% profit mark, but once they did they could begin to strengthen their positions which helps not just the bosses, CEO’s, & shareholders but benefits everyone. It’s neither communist nor socialist but does force people to do what Reaganomics claimed they would do on their own.

Easily Amused says:

Re: Deeper roots and broader solutions

BillJustin writes – “Force every American company or business that file taxes in the US to cap out at 15% profit. Every dollar over 15% net could be taxed at 85%. That would then force these companies to begin injecting their capital back into the economy rather than consolidating it for the shareholders.”

You do realize that such a system would be gamed to the point of being useless, right? Not to mention the grossly negative effect it would have on investment. I’m guessing you haven’t thought this idea through far enough to answer this, but what do you think the annual Federal budget would look like under your law? No company (or individual, for that matter) with a competent accountant would ever pay a dime of tax. ‘Net’ income would be even more malleable than it is now… Here’s an example for you- Widgets Inc. comes out with a new model that flies off the shelves ahead of estimated sales, and the company beats earnings estimates. They run the numbers and find out they made a 20% net. Do they avoid taxes by re-investing that 5% in R&D? Or do they split it up 1% to each VP, who only pay 15% of it in taxes as opposed to the corporate 85% rate?

Corporate income taxes represented 15% of U.S. tax revenue in 2007, care to explain how we are supposed to make that up, or what you are going to cut from the budget to account for the loss? Looking at several other charts from the tax policy center site will also show you that the top 20% of earners today pay an average of 26% income tax, with the top 1% paying almost 31%. I’m sure the very wealthy will enjoy keeping more of their money. The $63k/yr cutoff for personal tax would also eliminate the taxes that the middle third of households pay now, another 9% or so of the government’s budget gone.

Even if you managed to write a law that had no loopholes or shelters for companies/individuals to hide money in, you would have multi-billion dollar corporations making 13% profit paying nothing and a successful startup paying exorbitant sums.

Thinking that the corporations would all suddenly stop being ruthless and start planting trees and building bridges if they only had more money to spend and didn’t have to compete as much is insane. Thinking that the government would be capable of managing and regulating such a system (with little more than half their current budget, mind you) is drooling, lazy-eyed, Darwin Award-winning stupid.

BullJustin (profile) says:

Re: Re: Deeper roots and broader solutions

I have thought about this for quite a while, in fact since Forbes was making a name for himself advocating a flat tax. I’m sure you realize that the current system has been gamed to point of uselessness so that lacks any power as an argument. Of course people are going to try to keep as much as they can, hence the requirement for no tax shelters or loopholes. Several thousand people of the millions who make more than $200K per year pay NO taxes (see this report to learn how).

I hold no illusions that corporations will suddenly become good. I believe that every corporation and every executive within those corporations try to maximize profits in every possible way. The point of such a restrictive tax scheme is to force companies that would otherwise horde and consolidate their wealth at the top to trickle it down. Rather than successful startups paying exorbitant taxes, this scheme incentivizes sharing the windfall among everyone who helped. And yes, why not pour more money into R&D? Back when America was doing this we were unbeatable in our technological advances (remember Big Blue?). No one in the world could touch our ability to innovate, invent, and bring to market. Now innovation is stifled by restrictive copyright and patent law, invention is hampered by patent infringement lawsuits, and little productive and useful items get to the market. Now most of the innovation and advancement comes from Asia. America’s major export nowadays is entertainment. Entertainment needs to be pushed back behind a good work ethic and care for our fellow countrymen and visitors.

The strength of a nation and its economy is the people and the land. We continue to extract & consume natural resources at an unmaintainable rate. We continue to extract and consume the livelihoods of the middle and lower classes. How much tax do you think the government will be able to extract from its people as fewer and fewer people hold more and more of the money?

We cannot continue to feed off ourselves the way we have. Period. You don’t like my idea? Fine. What’s yours? You obviously did some research into it. What would the numbers have to be in the scheme to make fiscal sense to you? What if instead of a 3x Poverty Line it was 2x? What if it was 20% tax instead of 15%?

The vast majority of corporate income taxes come from just a few thousand corporations for whom the difference between executives and shareholders is great enough that they cannot get away paying the execs bonuses to alleviate their corporate taxes. By forcing these corporations to pay their excess funds to their employees to avoid taxation we will more than make up for any lost corporate income taxes from individual income taxes. A 13% profit cap also reduces the importance of quarterly earnings reports. Only companies that cannot reach the 13% cap would have great variability in their stock prices and those stocks would reflect the actual value of the company rather than the next quarter’s potential earnings statement.

One last thing. Personal attacks are the last redoubt of the indefensible. I know that GenX & the Millennials are great at pointing out where other’s ideas are flawed. I’m great at it. I don’t think this idea is the be-all-and-end-all of safe and smart fiscal planning. However, the state the economy is in, the fact that over 50% of our population now live in non-rural locales, and the drought that is starting to hit the Great Plains are going to force America into drastic action whether we like it or not. The stage is set very similar to what we saw in the 1920’2 and 1930’s. We cannot maintain the way we have and anyone who says all we need is a few minor tweaks is foolish. We must stop looking at individual gain and realize that united we stand but divided we fall. It is time to stop the division, to work for the betterment of the country and her people, and accept that every one of us will be making sacrifices before this is all through.

Easily Amused says:

Re: Re: Re: Deeper roots and broader solutions

First of all, there were no personal attacks in my comment, unless you are saying you actually believe the statements they were attached to, in which case, I stand by them.

Second, the numbers you put forth were your own – it took me all of 5 minutes of Google-fu and reading to expose the plan as obviously daft. As the originator of the idea, I assumed you had either done enough research to stand behind those choices, or hadn’t done any at all.

Aside from the details and figures, the biggest negative effects of the arrangement you propose are cultural. This system essentially teaches that you are allowed to be successful to a point, and then the government will step in and penalize you if you excel above your peers. Investment in anything high-risk would be pointless, as you would still have the large proportion of failures, but the small proportion of big winners would be limited to the same earnings cap. Where do you think innovation in this country would be without venture capitalists who are willing to lose big in the hopes of winning bigger?

How are you planning to regulate what a company does with it’s surplus? What makes you think they will give any to the employees? Why not just buy a new corporate jet and write it off as an expense to lower the tax burden? Nobody is going to risk the time and capital to innovate when the payoff is limited. What about the small business owner who manages to make a 20% profit and wants to put away that 5% each year so he can buy a new location and expand? Taxing him at such a rate will force him to borrow all the money up front instead of saving it. Aren’t we too dependent on credit already? I don’t think any Constitutional scholar would be okay with any government bureau telling a private entity what they can and can’t spend money on. This country was founded on the principle of personal freedom.

It is human nature to be competitive, sometimes to a fault. Every socialist’s and communist’s ideal society works great on paper, but fails miserably in the real world eventually because the basic tenets run counter to our primal urges. Some people will ALWAYS find a way to get more stuff, better stuff, more power, more influence, etc. Capitalism works because you don’t need to be indoctrinated in some cult of idealism (or religion or what have you), you just usually do what comes naturally. We set rules to prevent abuses and maintain some level of fairness because we are not animals. Individuals frequently don’t reach the level of ethical conduct we strive for as a whole, such as your tax dodgers in that link, but that is no reason for the government to be transformed from administration to overlord of commerce.

Without doing any math to find the right percentage point, the only flat tax scheme I could support would be truly flat, meaning all income private and corporate gets taxed at x% with no floor, ceiling, loopholes, or shelters. Incentives for charitable works and investment in the arts or infrastructure would be allowed. Of course, x% can be different for individuals and corporations, I would imagine the numbers guys could strike a good balance there. No incentives for remaining on long-term public assistance or being baby factories, no penalties for working hard, getting lucky, starting a family (or not starting one), or inheriting money that has already been taxed.

Economists have determined that the Depression lasted far longer than it had to because of overly interventionist fiscal policies, and the rate manipulation and regulation of fiat currency are a big part of why we are in trouble again now. If we can mandate to the politicians that they MUST reign in spending, get back on a global standard for the dollar, and stay the hell out of the way of the markets (allowing them to correct when necessary instead of jumping in to play mommy), we would be well on the way to a much more secure future.

BullJustin (profile) says:

Re: Re: Re:2 Deeper roots and broader solutions

I believe “drooling, lazy-eyed, Darwin Award-winning stupid” could be considered a personal attack, and it only makes your arguments less valid.

Good point about the VC & innovation. Obviously I have points yet to be considered.

There is no need to regulate what a company does with its surplus. if they choose to buy a jet then they have created jobs for a pilot, copilot, mechanics, and probably flight attendants, not to mention the downstream jobs bolstered by a staged and operating plane (fuel & distribution, rubber, electronics manufacturers, plane manufacturer, etc). So doing still forces the company to trickle down its excess profits to individuals in the economy. The most likely event would be bonuses for the company executives.

Animal nature is competitive, sompetition for resources to survive, be it land, food, shelter, whatever. Humans who fail to overcome their animal nature continue to be competitive because they are driven by a feeling of lack. Those who learn to control animal instincts tend to care more about others. And we all know some animals are more equal than others in their own eyes. Capitalism only works because its easy to be indoctrinated into the cult of capitalism. It works with our desire to get lots for little effort, or to build on the effort of others instead. The government already was an overlord of commerce. Deregulation left general commerce without a governing overseer.

A flat tax with any kind of incentives for charitable works, art investment, or infrastructure will be as abused as the current system. It may be that companies take a bigger stake in charities, arts, and infrastructure if they have such loopholes, but at what expense? A flat tax with a floor is still equitable. People who are struggling have a bit of safety, as do companies who are starting or haven’t hit it big yet.

The only tool the government has had in the past 20 years to manipulate the economy is the Fed. The Great Depression lasted way too long for just the reasons you submitted. Chances are this one will too since the Fed continues to fiddle with the interest rate. That and we have outsourced our production capability so much that even if we wanted to we couldn’t pull ourselves out of this mess anytime soon.

Of course, all this just academic. You and I and everyone else who reads these things have no real power to change anything, and those in office know this.

Steve R. (profile) says:

Radical Transparency

Mike wrote “The one thing I keep coming back to as a solution is to put in place some aspect of radical transparency on pretty much all aspects of financial instruments, both on the debt side and the equity side.”

Transparency as a solution, to a degree, is a red-herring like piracy. Transparency is easy to talk about, everyone can agree with, and makes for good sound bites. Nevertheless, transparency is somewhat of an oxymoron since ever more innovative complex products designed to game the system are anything but transparent. Nevertheless, I would agree that radical transparency is a must.

My take on a solution to our credit crisis is cultural. We have a schizophrenic culture. Our corporate executives are supposed to be leaders, responsible, have a social conscious, and work for the benefit of the company they work for. The reality is quite different. If their leadership proves faulty they do not take responsibility for their failures. Instead of working for the benefit of the corporation they are working for their own aggrandizement. If their entire industry is failing, instead of having a social conscious to work together to save the industry they demand golden parachutes for themselves and let the system fail.

It consistently amazes me that those who want to preserve the effective operation of the free market system seldom demand that executives, when they fail, be held accountable.

Twinrova says:

Preventing another crisis?

I believe there’s a saying about learning and repeating history, and today’s example proves this lesson is never learned.

I understand your obsession for trying to educate people on why the crisis happened, but you continue to overlook the fact as long as capital exists, there’s always a risk for a crisis, especially when those wanting more capital find loopholes in rules set up to protect the economy.

The entire model of “supply and demand” is one that’s been long, long overdue for a restructure. The reason why all economies use this model is they’re too damn afraid to change it. This whole crisis may have to do with this model, than with “transparency or suckers”.

These bundled “potential capital” packages fueled the S&D pipeline. There was a demand for these packages and it didn’t take long for several to take advantage of using past projections to sell future capital, lying to do so.

“Sure, this package will net you 15% capital gain!” only to watch it fail because the accounts in the package didn’t supply the capital. The “sucker” should have known better because of another popular saying: “If it’s too good to be true, it probably is.”

But when it comes to capital gains, it seems companies and individuals can’t seem to get enough of it and will continue to find ways to circumvent laws to get it.

I’m all for a global economic meltdown. I want major companies to fail and fade into memory. I want the dollar to reflect actual value, not virtual. I want a loaf of bread to drop below this dollar. I want Americans to realize their paychecks helps fuel this economy, and having more isn’t necessarily a good thing.

I’m fascinated by this site because of the attention the blogs gives to stories regarding corporate “greed”. The current IP issues we see shouldn’t be ignored, but they are. Consumers continue to buy, buy, buy and fail to realize what this does.

When we, as consumers, read news of financial giants going bankrupt because of the crisis they help with, we feel happy and glad to see them go. We challenge (but lose) the need for a bailout by voting 100-1 against it. “Let them fail!”, we cry.

Now there’s news of the “BIG 3” automotive companies declaring “We need help! Save us!” I don’t here the cries anymore for their departure, mostly because some of those yelling before are working for the “BIG 3”.

Funny how this works, isn’t it? Personally, the “BIG 3” should fade away into memory. They produced junk. They kept a model going for decades which put them in the position they’re in now. They refused to be innovative, and instead, continued to raise prices while using cheaper components.

I feel no pity for the “BIG 3”. It’s my turn to yell “Let them fail!” while understanding thousands will lose their jobs. But, it’s a necessary step. We need an automotive industry that’s reliable, innovative, and doesn’t bow to the oil companies by producing engines that waste. Honda is a world recognized leader in automotive technology, yet the most powerful nation on Earth isn’t? What the hell is wrong with this picture?

We live in a country where professional athletes make millions while families struggle to pay their bills due to this economy. We scream and cry about CEO salaries, but fail to realize ours only pushes prices higher. We blame everyone for the problems of the country but take no actions to stop by doing the simplest protest possible: Stop buying.

The only “sucker” in this whole scenario is the consumer.

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